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Familiar story – After all it has been through, could Serco really be heading back to square one?

29/01/2016

Andrew Lyddon

Fund Manager, Equity Value

As our readers will know we look at a number of stocks but don't always choose to hold them in the portfolio and Serco is one of those. Now christmas may be over for another year but, here on The Value Perspective, Serco remains the gift that keeps on giving. After three articles in the space of 12 months on the value lessons offered by the struggling business, we had resolved not to touch on Serco until it was on the road to recovery. But then that road hit another pothole and, well, you know what resolutions are like at this time of year.

The pothole in question was the warning the outsourcing business issued last month that its profits would almost halve in 2016. As we have mentioned before, most recently in Travail news, Serco used to be a real market darling but subsequent troubles, including a number of loss-making contracts, once again highlighted the dangers of a business with a weak balance sheet and high levels of debt.

More positively, in Rupert Soames, Serco now has a chief executive with a good reputation, who is trying to sort the company out – even if that has entailed two rights issues in the space of 18 months. As such, the business ought to be a classic recovery story but, while that is not yet how we see it, here on The Value Perspective, this piece is not going to be another rehash of why our thinking still holds.

Instead, we wanted to highlight how Serco has become a classic example of how the process of turning around a business that has been badly run in the past can take so much longer than people expect. To be fair, the new management has not been dragging its heels – for example, it has been selling businesses to generate cash to help bolster the company’s balance sheet.

At the same time, the team has been seeking to reduce Serco’s liabilities by renegotiating some of its more onerous contracts so that they end a good deal earlier and thus do not represent such a long-term drain on cash flows. In short, management has been doing some good things but, as mentioned earlier, it has also had to concede that 2016 profits will now be a good deal lower than expected. This isn’t necessarily their fault, but continues to be the product of mistakes Serco’s former leaders made in the past.

One of the problems here is that government contracts – Serco’s principal source of revenue – are not won overnight. The bidding process can take up to a couple of years and, even once the contract is awarded, the winning company is unlikely to see much in the way of profit in the first year or so as it invests in getting all its systems and processes up to speed.

The situation has been made worse by two other factors, the first of which is that, because of its well-publicised difficulties, Serco has been bidding for fewer contracts (and people have been less inclined to give it work anyway). Second, the company has lost a number of existing contracts – some bigger, some smaller but, cumulatively, a material amount.

All of this has led to a significant deterioration in Serco’s revenue outlook and, when revenues are set to be lower than expected, it usually follows that profits will be too. Aside from anything else, this has ramifications for Serco’s ratio of net debt to EBITDA (earnings before interest, taxes, depreciation and amortisation), which is one of our preferred ways of sizing up the strength of a company’s balance sheet.

At the start of the year, this ratio stood at about 1x, which is not particularly concerning for a business that might reasonably be expected to be somewhere near the bottom of its profit cycle. The problem is, as the loss-making contracts and planned restructuring leads to Serco consuming cash through 2016, its debt levels will continue to rise while its profits are falling.

As a result, by the end of the year, Serco’s net debt to EBITDA ratio is expected to be somewhere between 2x and 2.5x, which would be right back up at the kind of level where, here on The Value Perspective, we start to worry. Given everything the company has been through – and particularly all the money it has raised to pay down debt – it would be a remarkable situation to be back in so quickly.

Now, it may well be that, over the course of 2016, management can do all sorts of constructive things to avoid reaching that point. When forming a base case for what will happen, however, investors have to at least consider what management tell them to expect and that means – on a 12-month view and on this particular metric at least – Serco’s balance sheet looks set to be every bit as vulnerable as it was a year ago.

Equally, it may well be that 2016 proves to be the trough for Serco’s profits, which would mean that leverage ratio would start to improve again – and potentially do so quite rapidly - after all, the company’s actual debt level in £ terms is much lower and more manageable today than it was. On the other hand, should the company happen to see a further wobble in profits, a third equity-raising in just a few years would not be out of the question.

Still, that is the future – which, as we always point out on The Value Perspective, is by its very nature an uncertain prospect. It is Serco’s present situation that neither its investors nor indeed we, who do not own the shares, would have expected – after all the remedial work of its management team – to remain quite such a concern. Serco is a situation that we continue to watch with interest.

Author

Andrew Lyddon

Fund Manager, Equity Value

I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.

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